So you did all the research and decided that you would like to add an international stock fund to your portfolio. Then you pull up a list of all the available international stock funds and discover that there are over 400 options to choose from. Does it matter which one you pick? After all, they all intend to own international stocks. The answer is more complicated than simply choosing the international stock fund with the lowest cost.
When choosing a fund to invest in there are four primary pillars that we evaluate: intended exposure, investment style, tax efficiency, and cost.
We want to make sure that the funds we consider embody the characteristics of the asset class they intend to track. If a fund considers itself an international stock fund, we would want to know if the international allocation is developed international markets, emerging markets, or frontier markets. Rather than relying on the name of the fund, understanding how and where the assets are allocated can provide useful information regarding the risks it takes and how it could be incorporated into the portfolio.
The second pillar is determining what type of investment style the fund is using. There are many variations of investment styles that each come with their own risk profiles. There are active managers, who attempt to take advantage of perceived opportunities, and passive managers, who merely manage the fund to look like an index. These managers may specialize in buying cheaper stocks (value) or expensive stocks (growth) and small companies or large companies.
Knowing the investment style allows us to compare the funds to familiar benchmarks and see how differently they perform. Large unexpected performance differences could indicate that the benchmark being used is wrong or there are risk management issues within the fund, which would require further scrutiny. For most equity asset classes, RegentAtlantic prefers managers that own a broad set of companies in that space but overweight those that are of higher quality and that trade at attractive valuations.
Some funds generate a great deal of dividend distributions that are taxable as income. We would want to buy these funds in qualified accounts so that the distributions do not increase a client’s taxable income and potentially push them up into higher tax brackets. However, some clients may not have that option, so a careful analysis is necessary to understand the nature of the distributions and to consider how they would impact a client at tax time.
Funds could also generate capital gain distributions. When a fund sells stock in the portfolio either to cover redemptions or to rebalance, the gains generated on these positions are passed on to the investors. This means that investors will have to pay capital gain taxes even though they never sold the fund. Losses that a fund realizes, however, are not passed on to the investors – only reserved within the fund to offset future gains. To mitigate tax inefficiencies, our approach is to incorporate individual equities and ETFs in taxable portfolios where appropriate. It is not uncommon that we select a recommended mutual fund for tax deferred accounts and a similar, more tax efficient ETF for taxable accounts.
This brings us to the final pillar, cost. Funds summarize the cost of ownership using a net expense ratio and it is very useful to compare against other funds. The higher the expense ratio, the more expensive it is to remain invested in the fund and the lower the net-of-fees return – all else being equal. Cost is always relative to other funds in that asset class; for example, asset classes such as emerging markets and small international stocks tend to be more expensive to invest in than the S&P 500. Funds that are actively managed are typically more expensive than index funds. When we are given a choice between two similarly managed funds with different expense ratios, we prefer the lower cost fund.
With that said, a fund that is tax inefficient or is expensive does not necessarily mean it should be disregarded. There are some types of investments that are simply not tax efficient and are expensive but offer greater diversification to the overall portfolio.
Finding the right fund to get the desired allocation requires experience and is a balancing act of its relative strengths and weaknesses in each of the aforementioned pillars.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.